CUNA Regulatory Comment Call

January 5, 2006

EXECUTIVE SUMMARY

• The federal financial institution regulators, including NCUA, have issued proposed guidance on residential loans that allow borrowers to defer repayment of principal and loans that also allow borrowers to defer interest as well.
• These nontraditional mortgage loans include “interest only” mortgages in which the borrower has the option to pay no principal for a fixed period of time and “payment option” adjustable-rate mortgages in which the borrower has flexible payment options, including the option to pay less than the interest owed, resulting in negative amortization. Some financial institutions also combine these mortgage loans with other practices, such as making second-lien mortgages simultaneously and accepting reduced documentation in evaluating the applicant’s creditworthiness.
• Although the agencies recognize that innovations in mortgage lending may benefit certain consumers, they are increasingly concerned that these lending practices present unique risks that the institutions must manage appropriately. The agencies are also concerned that these loans are being offered to a wide spectrum of borrowers, including subprime borrowers and others who may not qualify for traditional mortgage loans or who may not fully understand the risks of these nontraditional loans.
• With regard to these nontraditional mortgage loans, the proposed guidance addresses the loan terms and underwriting standards, the appropriate portfolio and risk management practices, and the need for consumers to understand the terms and risks of these loans.
• Comments on the proposed guidance are due by February 27, 2006. Please submit your comments to CUNA by February 17, 2006.

Please feel free to fax your responses to CUNA at 202-638-7052; e-mail them to Senior Vice President and Associate General Counsel Mary Dunn at mdunn@cuna.com and to Senior Assistant General Counsel Jeff Bloch at jbloch@cuna.com; or mail them to Mary and Jeff in c/o CUNA’s Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, South Building, Suite 600, Washington, DC 20004-2601. You may also contact us at 800-356-9655, ext. 6032, if you would like a copy of the proposed guidance, or you may access it here.

BACKGROUND

In recent years, consumer demand has grown rapidly, particularly in high-priced real estate markets, for mortgage loans that allow borrowers to defer the payment of principal, as well as interest. These nontraditional mortgage loans, which include “interest only” and “payment option” adjustable mortgages, have been available in similar forms for many years. They allow borrowers to pay only the interest on the loan for a fixed period of time. The “payment option” loans, commonly referred to as “option ARMs,” also allow borrowers to pay less than the interest owed, resulting in negative amortization in which the loan balance increases. This allows borrowers to make lower payments during an initial period of time in exchange for higher payments later, as compared to traditional fixed-rate mortgages. These types of loans offer payment flexibility and can be an effective financial tool for certain borrowers.

Financial institutions are also increasingly combining these loans with other practices, such as making second-lien mortgages simultaneously and accepting reduced documentation in evaluating the applicant’s creditworthiness. The federal financial institution agencies are concerned because these practices present unique risks to the institution. The agencies are also concerned because these mortgage products and practices are being offered to a wider spectrum of borrowers, some of whom may not otherwise qualify for traditional fixed-rate or adjustable loans or may not fully understand the risks.

As a result, the agencies have developed the proposed guidance to clarify how financial institutions should offer these loans in a safe and sound manner and in a way that clearly discloses the potential risks that the borrower assumes. The agencies are also prepared to impose remedial actions on institutions that do not adequately manage the risks with regard to these types of loans, and they will seek to consistently implement the guidance.

BRIEF DESCRIPTION OF THE GUIDANCE

Loan Terms and Underwriting Standards

When a financial institution offers nontraditional loans, the underwriting standards should address the effect of a substantial payment increase on the borrower’s capacity to repay when loan amortization begins, while also complying with the applicable real estate lending standards, appraisal rules, and related guidelines. These standards should also address the issues below.

Qualification Standards – Nontraditional mortgage loans can result in significantly higher payments once the loan begins to fully amortize, which is commonly referred to as “payment shock.” This is of particular concern with option ARMs in which the minimum payments may result in negative amortization, leading to much higher payments when the loan begins to amortize.

A financial institution’s qualifying standards should recognize the potential impact of this payment shock and that these types of loans are inappropriate for borrowers with high loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios, and low credit scores. The analysis of the borrower’s repayment ability should include an evaluation of his or her ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. For loans that allow for negative amortization, this analysis should also take into account any loan balance increase that may result from the making of minimum payments. Institutions should also consider the risks the borrower may face if he or she chooses to refinance when the loan begins to amortize, such as any prepayment penalties.

The analysis of the borrower’s repayment ability should not overly rely on credit scores as a substitute for income verification. As the level of credit risks increases, the need to verify the borrower’s income, assets, and outstanding liabilities also increases.

Collateral-Dependent Loans – Institutions should avoid loan terms and underwriting practices that may result in the borrower having to rely on the sale or refinancing of the property once the amortization of the loan begins.

Risk Layering – Nontraditional loans that are combined with “risk-layering” features, such as making a second-lien mortgage simultaneously and/or accepting reduced documentation in evaluating the applicant’s creditworthiness, will pose increased risk. Under these circumstances, the institution should compensate for this additional risk with mitigating factors that support the underwriting process and borrower’s ability to repay, such as higher credit scores, lower LTV and DTI ratios, credit enhancements, and mortgage insurance. Institutions should also consider the affect of these features on estimated credit losses when establishing their allowance of loan and lease losses (ALLL).

Reduced Documentation – Financial institutions are increasingly relying on reduced documentation when making these loans. As the level of credit risk increases, the institution must apply more comprehensive verification and documentation procedures to verify the borrower’s income and the ability to repay the loan. Use of reduced documentation should be governed by clear policy guidelines and should be accepted if there are mitigating factors, such as a lower LTV and more conservative underwriting standards.

Simultaneous Second-Lien Loans – Simultaneous second-lien loans result in reduced owner equity and higher credit risk. Loans with minimal equity should not have a payment structure that allows for delayed or negative amortization.

Introductory Interest Rates – When initial monthly payments are based on low introductory rates, there is a greater potential for negative amortization, increased payment shock, and earlier recasting of the monthly payments than originally scheduled when the loan balance exceeds a certain level, as specified in the loan documents. Financial institutions should minimize the probability of such recastings and extraordinary payment shocks when determining the introductory rate.

Lending to Subprime Borrowers – Mortgage programs that target subprime borrowers should follow the applicable interagency guidance on subprime lending, which for credit unions includes NCUA Letter to Credit Unions 04-CU-13 – Specialized Lending Activities.

Non Owner-Occupied Investor Loans – Borrowers financing non owner-occupied investment properties should be qualified based on the ability to service the debt over the life of the loan, which should include an appropriate LTV ratio that considers the possibility of negative amortization and the ability of the borrower to make payments when the property is unoccupied.

Portfolio and Risk Management Practices

Nontraditional mortgage loans are untested in a “stressed” economic environment and should, therefore, receive higher levels of monitoring and loss mitigation. Institutions making or investing in these types of loans should adopt more robust risk management practices by:

• Developing written policies that specify acceptable product attributes, production and portfolio limits, sales and securitization practices, and risk management expectations.
• Designing enhanced performance measures and management reporting that provide early warning for increased risk.
• Establishing appropriate ALLL levels that consider the credit quality of the portfolio and conditions that affect collectibility.
• Maintaining capital/net worth at levels that reflect portfolio characteristics and the effect of stressed economic conditions on collectibility.

The following provides more information on the appropriate portfolio and risk management practices that financial institutions should develop with regard to nontraditional loans:

• Policies – The institution’s policies should set forth the acceptable levels of risk through its operating practices, accounting procedures, and policy exception tolerances. This should include growth and volume limits by loan type.
• Concentrations – In order to maintain portfolio diversification, concentration limits should be set for loan types, third-party originations, geographic area, and property occupancy status. Limits should also be set by other key portfolio characteristics, such as high combined LTV and DTI ratios, loans with the potential for negative amortization, loans to borrowers with credit scores below a certain threshold, and nontraditional loans with layered risks.
• Controls – For nontraditional loans, the institution should have controls to monitor compliance and exceptions to underwriting standards. This should include a regular review of a sample of reduced documentation loans and a sample of underwriters. Institutions should have strong controls over accruals, customer service, and collections. Employees should receive product-specific training on the features and issues associated with option ARM loans.
• Third-Party Originations – The institutions should have strong approval and control systems to ensure the quality of third-party originations and compliance with applicable laws and regulations, with emphasis on marketing and disclosure practices. These loans should reflect the standards and practices used in the institution’s direct lending activities. Monitoring procedures should track the quality of the loans to identify problems, such as payment default, incomplete documentation, and fraud.
• Secondary Market Activity – The sophistication of the institution’s secondary market risk management practices should be commensurate with the nature and volume of the activity.
• Management Information and Reporting – Reporting systems should be able to isolate key loan products, risk-layering loan features, and borrower characteristics in order to identify performance deterioration. At minimum, this should be available by loan type (for example, interest only and option ARMs), the combination of these loans with risk layering features, underwriting characteristics, and borrower performance (for example, payment patterns, delinquencies, interest accruals, and negative amortization). Portfolio volume and performance should be tracked against expectations, internal lending standards, and policy limits. Variance analyses should be performed regularly to identify exceptions to policies and thresholds, and qualitative analysis should be performed when actual performance deviates from established policies and thresholds.
• Stress testing – Institutions should perform sensitivity analysis on key portfolio segments to identify and quantify events that may increase risks in the portfolio. This should include stress tests on factors such as interest rates, employment levels, economic growth, housing value fluctuations, and other factors beyond the institution’s control that assume rapid deterioration in one or more factors in an attempt to estimate the influence on defaults and losses. The results should provide feedback in determining underwriting standards, product terms, portfolio concentration limits, and capital/net worth levels.
• Capital and ALLL – Institutions should establish appropriate allowances for the estimated credit losses in their nontraditional mortgage loan portfolios and hold capital commensurate with the risk. This should include segmenting their nontraditional loan portfolios into pools with similar risk characteristics, which typically includes collateral and loan characteristics, geographic concentrations, and borrower qualifying attributes. This should also include segmenting that distinguishes the loans by payment and portfolio characteristics, such as borrowers who regularly make minimum payments, loan balances that increase as a result of negative amortizations, and mortgages subject to sizeable payment shocks.

Consumer Protection Issues

Although nontraditional mortgage loans provide flexibility for borrowers, the federal financial institution agencies are concerned that consumers are entering into these transactions without fully understanding the terms and that this is exacerbated by marketing practices that emphasize the benefit without providing complete information about the risks. As a result, financial institutions should provide clear and balanced information about the relative benefits and risks, including the risk and consequences of payment shock and negative amortization.

Institutions must also ensure that they comply with applicable laws and rules. With respect to disclosures and other information provided to consumers, this includes the Truth in Lending Act and Regulation Z, as well as Section 5 of the Federal Trade Commission Act, which prohibits unfair and deceptive practices. Institutions must also comply with other fair lending laws, such as the Real Estate Settlement Procedures Act, as well as any applicable state laws. Institutions should monitor these applicable laws and regulations for any changes and should have counsel review their communications and other acts and practices in this area.

The guidance outlines the following recommended practices:

Communications with Consumers – The information should be presented in a clear manner and in a format such that the consumer will notice the information, understand its importance, and be able to use it as part of the decision-making process. This should include focusing on the information important to the decision-making, highlighting key information, employing a user-friendly and readily navigable format, and using plain language with concrete and realistic examples. Comparative tables and information may also be useful. Timing should also be considered, such as providing the information when the consumer is shopping for and deciding on a mortgage and not just at the time the application is submitted. Here is additional guidance regarding consumer communications:

• Promotional materials and descriptions should provide information that enables consumers to prudently consider the costs, terms, features, and risks of these types of mortgages, including the following information:
  • The potential increases in the payment obligations, including the timing of the payment changes.
  • The possibility of negative amortization and the consequences of any increase in the loan balance and any decrease in home equity.
  • Prepayment penalties (which do not apply to Federal credit unions).
  • Any pricing premium for consumers choosing a loan with reduced documentation requirements.
• Monthly statements provided for option ARMs should provide information so the borrower makes a responsible payment choice, including the impact of each choice on the principal balance. Encouraging borrowers to select the minimum payment option should be avoided.
• Institutions should avoid practices that obscure the significant risks to the consumer, which includes payment increases, negative amortization, and possible balloon payments.
• Institutions should avoid practices such as unwarranted assurances about future interest rates, inappropriate representations about the cash savings from nontraditional mortgages in comparison with amortizing mortgages, suggestions that the initial minimum payment in an option ARM will cover the accrued interest charge (or interest and principal), and misleading claims that the interest rate or payment obligations are “fixed.”

Control Systems – Institutions should develop and use strong control systems to ensure that these actual practices are consistent with their policies and procedures. These systems should address compliance and fair disclosure concerns, as well as safety and soundness considerations. Lending personnel should be trained to convey the information accurately about the terms and risks in a timely and balanced manner. They should also be monitored to determine if they are communicating the information appropriately. Institutions should also review any consumer complaints to identify potential compliance, reputation, and other risks.

Other comments?

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Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com Mary Mitchell Dunn • SVP & Deputy General Counsel • (202) 508-6736 • mdunn@cuna.com Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com Lilly Thomas • Assistant General Counsel • (202) 508-6733 • lthomas@cuna.com Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 • corr@cuna.com

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